Momentary Financial Crisis... And A Lesson In Unintended Consequences

from the watch-the-automated-trades-go-wheeeeeeeeee dept

As you may have heard, yesterday was a fun day when it came to the stock market, with something causing the Dow to go into freefall for a bit, before it then bounced back up. Initially, some thought that it was a full-on financial crisis, and then there were rumors of a "fat finger" trade, as has been seen in the past. Then there was the inevitable claims of high frequency trading systems having something to do with the mess. People are still figuring out all the details, but Bloomberg has a pretty good explanation of how things snowballed, and it appears to be a case of seriously unintended consequences. Planet Money has the shorter version of how a system designed to prevent the market going into freefall, may have actually aided the market going into freefall.

Basically, there's a system for the NY Stock Exchange and the NASDAQ, called the Liquidity Replenishment Point (LRP), which is designed to stop electronic trading on stocks in freefall. The idea, of course, is to prevent the algorithms from going nuts. But, the LRP only works on those two exchanges, and we're in a world now where there are a bunch of other, electronic exchanges, that now handle an increasing percentage of stock trades -- and electronic trading on those exchanges is not stopped when the LRP is triggered. So, now things actually get worse, because orders that used to be spread more widely concentrate on these other exchanges by automatically jumping from the NYSE and NASDAQ to those alternative routes, and it can swamp those systems, which have a lot less money available. As Bloomberg explains:

While the system is designed to restore order on the Big Board, trading is so fast during times of panic that orders routed past the exchange may swamp other venues and exhaust buy orders, said Angel at Georgetown.

That's when prices may plummet as orders execute against so-called stub quotes from market makers. Brokers can set the quotes as low as a penny a share because they're never expected to be used.

And, speaking of unintended consequences, in talking about this very thing, Felix Salmon points to a blog post by Kid Dynamite explaining why the plan to cancel many of the errant trades is monumentally stupid and likely to create more unintended consequences in forgiving people for doing stupid things, and taking away incentives for others to step in and fix things:

if buyers who step in later see their trades canceled, it removes all incentive for them to step in - and then you don't get the bounce back that we saw! Think about how much havoc it causes a trader who astutely bought cheap stock, then sold it out at a profit. He's now short! Or, he spent the entire day wondering if his order would be canceled, in a state of limbo. What's the alternative - that traders should just assume that the orders will get canceled, and NOT buy stock? Guess what - if no one buys, the stock stays cheap! SOMEONE has to buy, and that someone shouldn't be penalized in favor of remedying the ignorance of the seller who screwed up.

Ah, setting off more unintended consequences in response to other unintended consequences. Sometimes you just have to let those who made a mistake take responsibility for their mistakes.

Re:

Bailouts and Undos

People are still figuring out all the details,

What happened was that the wrong people lost a lot of money, and when that happens something will be done about it. Either the government will step in with a bailout or the system will just give the "wrong losers" a big "undo" (like five-year-olds demand when they lose).

LRP

The solution is to require federated/coordinated enforcement of the Liquidity Replenishment Point (LRP) across all exchanges. That some stock prices were allowed to drop 90+% in less than 10 minutes is not the fault of traders, it is a frightening market failure. Since the computers were making nearly ALL of the decisions during that period, it is hard to lay blame at human stock trading decisions.
[used 'less than' symbol in previous post which cut it off, please delete previous]

Having coded stock trade engines in the past ...

"Sometimes you just have to let those who made a mistake take responsibility for their mistakes."

Most of the time that is correct. If this turns out to be one or more hacked trade engine(s) (computerized trading system(s)), an attempt to profit from a statistical fluke someone found doing a historical simulation and then set in motion, or any of the other number of things that can be used to manipulate the market to cause money to unfairly change hands. In situations like this it is better to be safe than sorry and stop any profit from attempts at market manipulation. Rather than wait a year for the investigation to conclude and find that it was an externally forced event.

Complex Systems Are Prone to Failure

This is simply another example of "financial innovation" running amok. Previously we had the creation of CDOs which began to unravel. In doing so, it turned out that the holders of the CDOs could not even figure out who actually owed them the money because the underlying securities were sliced-up and re-sliced as to be unrecognizable. Truly a black box.

Now we have people writing psychic programs to "sense" the anticipated movement of a stock. Unfortunately it looks like someone may have created a positive feedback loop. Oops!

My point, given the freedom to innovate, these companies should exhibit a degree of self control and ethical behavior. These "people" in their self-serving greed don't seem to care that their mistakes could destroy our economy and the lives of others. Given this greed, I'm probably on the wrong planet with my recommendation!

Re: Complex Systems Are Prone to Failure

"My point, given the freedom to innovate, these companies should exhibit a degree of self control and ethical behavior. These "people" in their self-serving greed don't seem to care that their mistakes could destroy our economy and the lives of others."

Perhaps after passing your seven you should also be sworn in with an oath like the hippocratic oath or an Officer of the court and held to a higher standard. Alot of good that does us with Officer of the court though.

high frequency trading

Its a joke to talk about stopping high frequency trading and/or day trading. Where does the liquidity come from for the average working guy to buy and sell stocks for his account from home at brokers like ETrade and TDAmeritrade? From active day traders for one. Get rid of day traders and there goes the nice tight bid-ask spreads everyone enjoys right now. Practice good money management and you don't have to worry so much about events like the above happening.

Re: high frequency trading

I agree with you Barry. If they got ride of the day traders, there would be less liquidity in the market. as day traders we provide the liquidity for a majority of the moves during the day. Hedge funds and institutional traders are not interested in high frequency trading and they don’t care about gaining 50cents to 2 dollars a day, they are after the big long term moves, but as day traders we make it possible for the other people to have daily liquidity. This has been a very interesting article.

Forex Trading

"Since the computers were making nearly ALL of the decisions during that period, it is hard to lay blame at human stock trading decisions." This is true but both are at fault since everyone should take responsibility about it.

Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance. Thanks.
Regards,banking information